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The liquidity effect in the federal funds market: evidence from daily open market operations

  • Seth Carpenter
  • Selva Demiralp

We use forecast errors made by the Federal Reserve while preparing open market operations to identify a liquidity effect at a daily frequency in the federal funds market. Unlike Hamilton (1997), we find a liquidity effect on many days of the reserve maintenance period besides settlement day. The effect is non-linear; large changes in supply have a measurable effect, but small changes do not. In addition, a higher aggregate level of reserve balances in the banking system is associated with a smaller liquidity effect during the maintenance period but a larger liquidity effect on the last days of the period.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-61.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-61
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  1. Demiralp, Selva & Farley, Dennis, 2005. "Declining required reserves, funds rate volatility, and open market operations," Journal of Banking & Finance, Elsevier, vol. 29(5), pages 1131-1152, May.
  2. Pagan, A.R. & Robertson, J.C., 1994. "Resolving the Liquidity Effect," Papers 277, Australian National University - Department of Economics.
  3. Bernanke, Ben S. & Mihov, Ilian, 1998. "The liquidity effect and long-run neutrality," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 149-194, December.
  4. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March.
  5. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34.
  6. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring Monetary Policy," NBER Working Papers 5145, National Bureau of Economic Research, Inc.
  7. James D. Hamilton, 1996. "Measuring the liquidity effect," Working Papers in Applied Economic Theory 96-06, Federal Reserve Bank of San Francisco.
  8. James A. Clouse & Douglas W. Elmendorf, 1997. "Declining required reserves and the volatility of the federal funds rate," Finance and Economics Discussion Series 1997-30, Board of Governors of the Federal Reserve System (U.S.).
  9. Cochrane, John H, 1989. "The Return of the Liquidity Effect: A Study of the Short-run Relation between Money Growth and Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(1), pages 75-83, January.
  10. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  11. Seth Carpenter & Selva Demiralp, 2008. "The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 1-24, 02.
  12. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  13. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," Working Paper 91-17, Federal Reserve Bank of Atlanta.
  14. Gali, Jordi, 1992. "How Well Does the IS-LM Model Fit Postwar U.S. Data," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 709-38, May.
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